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Inbound transition rule for MTM election

I received the following question from reader K:

I have client who filed as a nonresident in 2013 and previous years. In 2014 he passed the substantial presence test and is filing a resident return. He has an Australian mutual fund that he has had for years. He only has his 2013 and 2014 year end statements. Can we make a mark-to-market election for him using his 2013 year end value as his adjusted basis? Or do we need to determine what his actual cost basis is?

The short answers to those questions are: You can make the MTM election using the 2013 year end value as the adjusted basis, but you still need to know the actual cost basis for when the fund is sold.

I will assume that the fund is a marketable security under IRC §1296(e), and that K’s client is therefore eligible to make the MTM election. I will talk about how to compute the MTM gains when the first year of US tax residency is 2014, and how to compute your gains when you sell the mutual fund in 2015.

MTM election basics

The MTM election rules are found under IRC §1296. When you make the MTM election, you compute the annual increase or decrease in market value of a PFIC and report it as an ordinary gain or loss on your tax return. The ordinary losses, however, are limited to the amount of ordinary gains previously recognized (and the running total of how much ordinary loss you are able to take is called “unreversed inclusions”).

Each year you are recognizing gain equal to the increase in market value. Your basis in the fund increases accordingly. In the case of K’s client, the fund was owned for years before the client became a US person for tax purposes. Therefore, it is a reasonable question to ask for an inbound immigrant: Do I calculate my first year of MTM gains based on the market value of the end of the previous year, or based on my actual purchase price from years ago when I was not a US person?

Luckily, Congress has addressed this directly in the Code.

Inbound transition rule

IRC §1296(l) states:

If any individual becomes a United States person in a taxable year beginning after December 31, 1997, solely for purposes of this section, the adjusted basis (before adjustments under subsection (b)) of any marketable stock in a passive foreign investment company owned by such individual on the first day of such taxable year shall be treated as being the greater of its fair market value on such first day or its adjusted basis on such first day.

In other words, your PFIC gets a step up in basis to fair market value as of the first day of your first taxable year as a US person for the purposes of MTM calculations, if the fair market value as of that day happens to be greater than your actual basis in the PFIC. I assume that is the case for K’s client: that the market value at the end of 2013 is greater than his actual basis in the fund.

Note that the basis step-up applies only for the purposes of MTM calculations. That means that the basis step-up does not apply for other purposes.

Basis step up for MTM calculations only

The Regulations demonstrate, by example only, how the calculations work for non-MTM purposes. Because there is no additional explanation, I will show the entire example from Regs. §1.1296-1(d)(5) here:

A, a nonresident alien individual, purchases marketable stock in FX, a PFIC, for $50 in 1995. On January 1, 2005, A becomes a United States person and makes a timely section 1296 election with respect to the stock in accordance with paragraph (h) of this section. The fair market value of the FX stock on January 1, 2005, is $100. The fair market value of the FX stock on December 31, 2005, is $110. Under paragraph (d)(5)(i) of this section, A computes the amount of mark to market gain or loss for the FX stock in 2005 by reference to an adjusted basis of $100, and therefore A includes $10 in gross income as mark to market gain under paragraph (c)(1) of this section. Additionally, under paragraph (d)(1) of this section, A’s adjusted basis in the FX stock for purposes of this section is increased to $110 (and to $60 for all other tax purposes). A sells the FX stock in 2006 for $120. For purposes of applying section 1001, A must use its original basis of $50, with any adjustments under paragraph (d)(1) of this section, $10 in this case, and therefore A recognizes $60 of gain. Under paragraph (c)(2) of this section (which is applied using an adjusted basis of $110), $10 of such gain is treated as ordinary income. The remaining $50 of gain from the sale of the FX stock is long term capital gain because A held such stock for more than one year.

As you can see, K’s client does get the basis step-up in his inbound transition year for the MTM election, but he will also need to know his original basis in the fund because he will need to compute gain upon sale under IRC §1001 for the portion of the gain not included in income under the MTM rules. That portion of the gain will be a capital gain.

Example

Let’s use the following numbers to do some calculations:

Assume that K’s client (let’s call him Tom) purchased the fund for $100 in 2006. At the end of 2013, the value of the fund is $150. At the end of 2014, the value of the fund is $160. In June of 2015, Tom sells the fund for $180.

2014 calculations (inbound immigration year)

Because of the basis step-up rule, Tom’s basis in the fund for MTM purposes is $150. He has a $10 MTM gain for 2014 because the market value of the fund at the end of 2014 is $160.

On his 2014 tax return, he will report a MTM gain of $10 on Form 8621 and include $10 of ordinary income on Line 21 of Form 1040.

His new adjusted basis in the fund for MTM purposes is $160. His new adjusted basis for all other purposes is $110 ($100 purchase price + $10 MTM gains).

2015 calculations (year of sale)

On his 2015 return, Tom will report the sale of his PFIC. Because the price of the fund increased in 2015, Tom will have to report both a MTM gain in 2015 and a non-MTM gain for the appreciation in value before he met the substantial presence test.

His MTM gain is the difference between the proceeds ($180) and his adjusted basis for MTM purposes ($160), or $20. He will report the sale on Form 8621, showing a $20 gain, and will include $20 of ordinary income on Line 21 of Form 1040.​

For his non-MTM gain: His actual basis in the fund when he became a US person was $100, his original purchase price from 2006. That basis for purposes other than MTM calculations increased to $110 when he reported $10 of MTM gain on his 2014 tax return.

He had $70 of gain when he sold ($180 proceeds minus $110 adjusted basis), $20 of which was ordinary MTM gains reported on Form 8621 and Line 21 of Form 1040. The remaining $50 will be a long term capital gain reported on Schedule D.

In effect, the amount of capital gain recognized upon sale is equal to the amount of basis step-up taken under IRC §1296(l) in the first year of US person status.

Summary​

For the purposes of MTM calculations only, inbound immigrants get to use the greater of their actual adjusted basis or fair market value on the first day of the first year of US person status under IRC §1296(l) when they make the MTM election in the first year of their US tax residency.

When they dispose of the PFIC, however, the portion of the appreciation not recognized under the MTM rules, either at the time of basis step-up or subsequently in the holding period, is a capital gain.

Thank you

Thank you for reading, please consult a professional if you need tax advice, and I’ll see you in two weeks.